Distress, risk aversion drive a new European property dynamic

ECB HQ

Despite the torpor, self-inflicted pain, failure of political leadership and rather anemic outlook for Europe's economy, the European real estate market has continued to attract substantial amounts of capital from both European and global sources. However, investors have gravitated to the most core of core properties and markets amid the uncertainty.

While investors are right in doubting the robustness and credibility of current policy there is, at the same time, increasing clarity regarding the source and nature of the opportunity in the region's real estate market.

Investors waiting to underwrite a full-blown recovery in the region will simply miss the opportunity currently unfolding in the region:

  1. The market has moved into a position where investors are being rewarded for the additional risk associated with the opportunistic segment of the market, the first time this has happened in a good number of years.
  2. There is clear evidence that banks and other distressed sellers have begun to take a more realistic position on valuation and pricing to the point where the bid-ask spread in the opportunistic market has narrowed to the point where deals are capable of being executed.
  3. While a new phase of opportunistic investment has taken hold in the region, it is a phase that is dramatically different from anything seen before. The lack of growth expected in the market and the general lack of debt in the foreseeable future place the emphasis squarely on the abilities of the asset manager to drive investment returns. Asset managers with the requisite mix of financial and operational skills are few and far between and, as a result, command a significant competitive advantage in this new market.

Three trends support the new dynamic

The new phase of opportunistic investment in Europe is underpinned by three distinct elements — extreme risk aversion, the aftereffect of assets that have been in suspended animation for the duration of the downturn and the degree of divergence and polarization in the market. Three clear trends that combine to provide a wonderful playground for seasoned opportunistic investors.

Extreme risk aversion

The sort of economic and political conditions that have prevailed during the past four to five years have driven not just a modest lowering of appetite for risk but also an extreme risk aversion.

During this period, the European market has attracted substantial amounts of liquidity but most capital has been focused on core investments in the largest and most transparent markets in the region. This has clearly driven pricing higher at the core end, but it is also responsible for something much more important: It has led to a redefinition of the very essence of core.

Extreme risk aversion has led to a retrenchment of investor attitude to the point where a "core asset" has to tick every box. It has to be perfect in every way — location, covenant, lease length, occupancy and so on — leaving behind a whole swath of institutional assets, some with minor blemishes capable of being rectified through an injection of equity or active management. As a result, highly institutional assets are, to all intents and purposes, being priced into the secondary market. As the region continues to stabilize, these assets will reprice quickly as domestic institutions become the dominant sources of capital once again.

Assets in suspended animation

The likely level of distressed sales in the opportunistic market in the next three to four years will total at least €250 billion. This contrasts with around €60 billion of capital available to opportunist funds now targeting the region, a ratio of 4:1.

These assets have been in suspended animation for the past five years. The owner has lost most, if not all their equity, and the bank is clearly not willing to inject new equity to maintain values. More often than not, the bank does not have the sort of asset management skills required to maintain value. The original strategy of "extent and pretend" relied on a recovery taking hold by now. The delay to a robust recovery has meant that values have continued to fall for these assets. Moreover as banks continue to improve profitability, they have begun to write down those values to the point where bid-ask spreads have narrowed to the point where deals can be executed.

Polarization

Europe has tended to be painted with the same broad brush with the real differences between markets largely overlooked or glossed over. There remain significant differences in performance across all residential and commercial real estate markets. For example, the central Paris office market remains incredibly tight with less than a one year supply. In such a market, it is entirely appropriate to consider taking leasing risk as well as refurbishment and development risk. By way of contrast, Amsterdam now has in excess of five years of supply. Much of its office stock will never return to productive use and the opportunity is largely centered on changes of use. This divergence and diversity will continue to prevail and, as such, provides a rich landscape for opportunistic investors.

Conclusion

The real estate market has quickly moved in favor of opportunistic investors. The sort of market conditions prevailing will mean this phase of opportunistic investment will be radically different from anything we have seen before. Perhaps most important is the lack of growth, availability of debt and increasingly polarized performance that will preclude investors from taking macro positions on the European region. The engine of a successful opportunistic strategy relies fundamentally on the ability of an asset manager to select appropriate stock and add value against a rather anemic economic environment.

Joe Valente is managing director, head of research and strategy for J.P. Morgan Asset Management (JPM)'s European real estate group.